Small business owners often feel they have sufficient time to begin making the transition and will delay the necessary steps until some fateful event forces them into acting. This leaves little or no time to prepare the business and the family for the burdens, both financial and managerial, that can be caused by a sudden and unplanned transfer.

If you are currently the owner of a business there will be several questions you will want to consider for your planning:

• Would your family be better off by selling the business or remaining owners?
• Will one or more members of the family desire and be capable of managing the business?
• Do you plan to retire and/or intend for the business to fund your retirement?
• What financial, legal and tax issues do you anticipate?

Once you and your advisor have considered each of these questions, you should be able to take the initial steps necessary to transfer your business.

Family Considerations.

Some family-owned businesses cannot be managed by a “hands-off” board of directors and needs one highly-involved person alone at its helm. You will want to consider which members of your family would both desire and be capable of being the manager of the business. In most situations there will be one obvious choice, but do not assume your other children will not either want some control or want to be compensated for their portion of the business. Discussing your plan with your family can be a delicate matter, but you may be able to avoid future conflicts at less opportune times. Some family members will want nothing to do with either earning a salary from the business or being an owner of the business. In addition, it is often the case where a small business produces only enough income to support one owner. Thus, planning to leave the business to one arranging either for compensation or extra bequests to the others can be a practical and necessary step to preserve the business and family unity. If comparable assets are not available to offset a gift to one child, then the business owner will often purchase life insurance that will benefit the other siblings.

Transfer of Management.

Once you have determined who or who will not be continuing in the business, you should begin preparing them for their future duties. Most prepare the next generation for their role through their active participation in the business. Through this experience they will become familiar with your business, your contacts, your industry, and the day-to-day tasks that the job entails. Further, there should be an opportunity for the employees and the successor to become familiar with each other. If that prospect seems frightening, then consider sending them to work at a similar business where they will be able to mature and fine-tune their business skills.

Transferring the Business.

Determining the method by which the business should be transferred will depend significantly upon the parties’ ability to fund the transfer, the owner’s need for cash, and the legal and tax consequences of the transfer. The factor most likely to affect the transfer is the funding of the transfer. If the business has significant value, then it may be difficult for the child to purchase the business outright and compensate their parents or siblings. If the business is not to be transferred until death, then life insurance can be used to compensate those children who will not be continuing in the business.

If you, as the owner, are not interested in being paid by your children or if the business has little value apart from the people providing labor, then you may be able to simply start gifting interests in the business to your children. Gifting can utilize the annual gift tax exclusion (currently $13,000 to each recipient) to transfer a portion of the business each year, usually based upon the appraised value of the business. To accomplish this annual gifting you will need to assign shares or membership interests each year. And, yes, you will need to go through that formality to have the IRS consider it having been done properly. An additional benefit of annual gifting is that it can be used to reduce your Maryland estate taxes as well. Alternatively, the owner can use their last will and testament or a trust to transfer your business to your children, but you should certainly contact your attorney to see what will be the best method.

If you will be transferring the business and expect some compensation, then you will be able to structure the transfer using similar methods used between unrelated parties. Your ownership interests in the business can be transferred in accordance with a buy-sell agreement whereby your child can purchase interests in the business from your estate. To assist the child with their purchase of the business, you or the child could purchase the child a life insurance policy payable on your death. The proceeds of the insurance policy can be used to purchase the interests from your spouse and provide money for their future use.

Tax Planning.

A transfer of a business can involve both income taxes, local transfer taxes, as well as both federal and state estate and gift taxes. Despite the federal estate tax having been raised, here in Maryland, you begin to have state death tax issues once your estate reaches $1,000,000, if transferring to your children. If you are transferring property at your death to someone other than your children, then Maryland death taxes begin with the first dollar transferred; no matter what your total wealth may be. Your tax attorney can assist you with transferring the business in the most tax efficient manner.

If the transfer is structured as a sale, then you should be aware of the income tax consequences. Most assume that the sale of a business always creates capital gains income. This is not always the case, and those items taxed at ordinary income tax rates can create a very large tax bill. One ordinary income item is the taxation of “recapture” income. When a business owner sells property that he earlier depreciated, if the amount realized from the sale is more than the adjusted basis (roughly, what’s left to be depreciated) then the property owner is considered to have recapture income. Essentially, it means you overshot the true depreciation of the asset and the IRS wants its money back, despite the fact you were likely using an IRS-required depreciation formula to calculate it.

Planning for Legal Issues of Your Family.

In addition to the obvious tax and legal issues associated with the transfer of a business, the personal and legal issues of you and your family can complicate matters. These issues usually must be considered when structuring the transfer or the consequences can be dire. For instance, you or your children could possibly have debt or spending issues, and transferring the interests to them could suddenly make your business subject to the claims of your child’s creditors. Another possible issue could be your child’s current or future marital status. While gifts and inheritances left to children generally will not be considered marital or community property in most states, the way you structure the transfer of the business to your child or your child having access to income from the business could cause property division and support issues if your child’s marriage takes a turn for the worse.

If your child has potential legal issues that could jeopardize their holding and benefiting from a transferred business interest, you may want to consider some other arrangement. For instance, you may may want to delay giving the business to your child until a later date when your child (or their marriage) matures. Rather than giving an interest in a business directly to your child, you can have the stock held in a trust for the benefit of the child. The trustee can distribute income from the business to the child, but, since the child will not own the stock, it may limit the risk of claims of creditors or divorce attorneys. Once the foreseeable legal issues have passed, you may then have the trust distribute the stock to the child, or even to a grandchild.

Conclusion.

Successful succession planning improves the odds that a business will survive into a second generation. We have all seen the consequences of when a child is thrown into the position of being an owner and manager of a business without proper preparation. While the child may be grateful for the opportunity to step into a business, only through proper planning will this gift be a blessing and not a burden.

For additional information or to discuss transferring a business, please contact Jeff Rogyom at (410) 929-4578.

Tax attorneys likely have knowledge of the IRS standards used when approving an installment agreement or an offer-in-compromise and, further, may know a taxpayer’s likelihood of success with either option.  In addition, they may know the best way to utilize the IRS statutes of limitations for collection and whether it too can benefit the taxpayer.  Of course, a tax attorney whose law firm also offers bankruptcy services may know those situations when bankruptcy is a more effective solution, and, conversely, not offering bankruptcy services likely eliminates from suggestion most of those nationwide offer-in-compromise mills we all know.

To determine whether taxes will be dischargeable through bankruptcy, your tax attorney will look at the age of the taxes due, the type of tax due, when and if tax returns had been filed, and whether their are any special circumstances, such as fraud which could prevent discharge.

While there are many exceptions, there are three general rules in determining whether an income tax debt can be discharged through bankruptcy.  To be discharged in bankruptcy:

1. the tax must be for a tax year for which the tax return was due (including extensions, if taken) more than three years prior to the filing of the bankruptcy petition;
2. the tax returns must have been filed more than two years before filing the bankruptcy petition; and
3. the tax must have been “assessed” more than 240 days prior to filing the bankruptcy petition.

In addition to the above general rules, additional rules can extend the statutory periods so the tax debt may not be dischargeable until a later time.  If you intend to file for bankruptcy and have tax debts, then you should certainly discuss with your attorney whether those debts can be currently discharged and determine whether delaying the bankruptcy filing to discharge the tax debt would be in your best interests.

Under some circumstances certain tax debts may never be discharged in bankruptcy.  Some tax debts relating to employee withholding, as well tax debts resulting from fraud or tax evasion, can never be discharged regardless of the passing of time.  Further, while the tax debt may be wiped clean by the bankruptcy, tax liens the IRS filed prior to the bankruptcy will likely survive the bankruptcy.  Therefore, if the IRS has a lien on your home and you sell the home a month after filing for bankruptcy, then, while the underlying tax debt may be gone, the tax may still be collected from the proceeds of the sale via the IRS’s lien on the home.  The lien remains in place until the IRS collection statute of limitations expires, which generally will be 10 years from the date the tax was assessed.

If your primary debts are tax related, then your lawyer should assist you in determining whether your best option is to just file bankruptcy or to utilize one of the IRS relief programs.  If your income or assets, for instance, make the success of an offer-in-compromise unlikely or make the payments under an installment agreement too high, then differences in the ways such income or assets may be calculated under bankruptcy laws may make bankruptcy a better choice.  Conversely, bankruptcy is certainly not always going to be the best choice and, for some people, bankruptcy may not even be available.  Your attorney should be able to advise you as to whether an offer-in-compromise, an installment agreement, bankruptcy or simply the passing of time may be your best option to resolve your tax debts.

Because of the complications in determining whether bankruptcy is an option for discharging your tax debts, you should certainly seek the advice of an attorney that has experience in tax matters.  Unfortunately, because of the ongoing issues with the economy, many attorneys have switched their primary practices to bankruptcy, and many may not understand the ins and outs of bankruptcy rules as they relate to taxes, much less the non-bankruptcy options available.

While there may be a stigma to filing bankruptcy, those with tax debts have often been forced into relying upon bankruptcy because of the IRS and its collection practices.  Using a bankruptcy filing is often the quickest and surest way of solving some tax issues, and bankruptcy should not be forgotten as a possible solution.

For additional information or to discuss your tax debts or possible bankruptcy, please contact Jeff Rogyom at (410) 929-4578.

Beside the practical business and tax benefits, a buy-sell agreement also allows the parties to plan in advance of the moment when the ownership change will eventually occur, and, thus, allows the parties to avoid much of the tension and emotion that can result from delaying such discussions.  In addition, the buy-sell agreement also forces the parties to consider financial issues that often can only be solved if addressed well in advance, such as whether the company should purchase life insurance to fund the transfer.

The buy-sell agreement is a legal contract that dictates how, when, and for how much a company or remaining owners will be required to pay to acquire the interests of a departing owner.  The buy-sell agreement will typically provide for various triggering events that will either gives one party the obligation or the option to buyout the interests of another.  Typical events include: death, disability, divorce, bankruptcy, retirement, or otherwise changing their role in the company.  Many owners will be concerned about the ownership rights and control of the company.  Other owners will want to ensure payment for the departing owner, and still other owners will want the buy-sell agreement to minimize the tax burdens of the company and the departing and remaining owners.  Thankfully, buy-sell agreements are not one-size-fits-all, and an attorney will be able to address many, if not all, of these concerns.

While an attorney is virtually unlimited in choices that can be made in drafting and implementing the buy-sell agreement, there are primarily two types of agreements: the redemption agreement and the cross-purchase agreement.  Of course, even this choice can provide alternatives, such as a mixed agreement that allows members or shareholders the option to purchase the interests of the departing owner before requiring the company itself to purchase the owner’s interests.

Redemption Agreements

A redemption agreement will cause the entity to purchase the interest of the departing owner.  Many favor using the redemption agreement for buy-sells because of its simplicity, particularly when there are numerous owners.  If life insurance is needed to fund the purchase, a redemption agreement will typically require the purchase of only one policy.  And, since the company purchases the interests of the departing owner, no particular owner will have their interests increased in relation to the other remaining owners.  Of course, if one remaining owner already controls a substantial position of the company, then this could push that owner over a threshold such as the 50% ownership mark or other critical amount designated in the company’s bylaws or operating agreement.

While a redemption agreement has its advantages, it does have its limitations as well.  The redemption agreement will cause the entity to purchase the interests of the departing owner.  Thus, while the value of the remaining owners’ interests will increase in value, the shareholders of a c-corporation will see no increase in their tax basis.  So, when those shareholders sell their interests in the c-corporation, they will pay gain on the increased value of their shares.  In contrast, the tax basis of remaining s-corporation shareholders and partners in an LLC or partnership can be increased, regardless of whether the chosen method is a cross-purchase or a redemption.

In addition, if the entity using the redemption agreement is a c-corporation, then attribution rules may prevent the redemption from being considered a “complete redemption”, and, thus, may be considered taxable as a dividend to the departing owner.  This is particularly relevant when the remaining owners are closely related to the departing shareholder.  Further, a redemption of c-corporation shares may have alternative minimal tax consequences if the corporation receives insurance proceeds to fund the transfer.

Regardless of the entity’s tax status, insurance proceeds going to an entity to fund a buy-sell redemption agreement may be subject to claims of the entity’s creditors.   A redemption agreement, on the other hand, requires only one life insurance policy per owner and is typically the simplest transfer to structure and implement.

Cross-Purchase Agreements

A buy-sell agreement can also be structured as a cross-purchase agreement.  The cross-purchase agreement can be more complicated.  The cross-purchase agreement requires that some or all of the remaining owners be required to purchase the interests of the departing owner.  If life insurance will be used to finance the purchase, then each owner may need a policy on each of the other owners.  The individual owners would receive the insurance proceeds and will then use the proceeds to purchase the interests of the departing owner.  Since the individual owners, rather than the corporation, purchases the shares, this removes the tax basis issues that exist for c-corporations under a redemption agreement.  Further, for c-corporations, since the individuals receive the life insurance proceeds, the corporation should not encounter any corporate alternative minimum tax issues.

Mixed Agreements

Mixed agreements are those providing options to buy the interests by either the entity or the remaining interest holders followed by either the remaining interest holders or the entity having the right or obligation to purchase.  Either of these parties may purchase life insurance to fund the transfer.  Of course, the agreement can allow new parties to purchase the interests, such as a child of the departing owner.

Funding the Transfer

While much has been discussed in this article regarding the use of life insurance policies to fund buy-sell agreements, life insurance may not be  helpful if it is likely an owner will desire to sell their interests to fund their retirement.  In such case, the entity has several options.  The entity or remaining interests holders could, of course, stockpile cash over time through investments.  In addition, the parties may use insurance policies that will accumulate a cash value.  Still another possibility is the use of an installment agreement whereby the shares are purchased over time from either the entity’s future earnings or through dividends to the remaining interest holders.  Again, if the departing interest holder continues to have interests in the entity, whether directly or through IRS attribution rules, the departing owner of a c-corporation may be considered to have received dividends rather than capital gains.  Depending upon the tax rates then in effect, the IRS the reclassifying the payments as a dividend may have a negative effect.

Estate Tax Uses

The buy-sell agreement generally provides some method of valuation of the owners’ interests, whether by calculation or a fixed amount.  The value, as calculated under a buy-sell agreement, can often be used for estate tax valuations.  The IRS; however, may challenge values to be used for inter-family buy-sell agreements, particularly when the amount is less than reasonable and cannot be justified.  In choosing whether to use a cross-purchase agreement or redemption agreement, a person concerned about estate taxes may favor a cross-purchase agreement.  If an owner dies controlling the majority of a business that used a life insurance policy to fund a redemption buy-sell agreement, then both the business and the life insurance policy could be considered owned by the person’s estate.  Since entity-owned policies are typically used for redemption agreements, this situation may favor the use of cross-purchase agreements for owners with estate tax issues.

In Summary

Buy-sell agreements provide many benefits to business owners, but careful consideration should be used when determining how the buy-sell agreement should be structured.  Since buy-sell agreements are naturally forward-looking, reasonable projections must be made regarding financial requirements, both for funding and valuation purposes.  Moreover, when ultimately the success of the buy-sell agreement requires that the business survive, consideration should be given to ensure the future owners are given the necessary means and training to make this transition successful.  Your attorney, in drafting your buy-sell agreement, should be willing to meet with the owners, financial planners, accountants and any other individual needed to ensure the buy-sell agreement meets the current and long-term goals of the owners and the company.

For additional information or to obtain a buy-sell agreement for your company, please contact Jeff Rogyom at (410) 929-4578.

A divorce settlement is not considered a taxable event by the IRS.  Thus, a transfer between spouses that is “incident to divorce”, as defined by the IRS, will not be treated as a sale.  While this may sound great, it also causes many to forget that the property being distributed may be equal in value but not equal for tax purposes.  Since it is not considered a taxable event, the person taking the property will have the same “basis” in the property as when initially purchased.  When that person sells the property, they will have to pay capital gains tax at the time of the sale on all of the appreciation, even if the appreciation occurred while married.  This can cause otherwise equal distributions to be unequal if one person receives property with a lower basis.

The property settlement should also consider the overall taxability of the assets.  For instance, if the spouses split the marital property with one spouse receiving appreciated stock and the other receiving the family’s primary residence, then the spouse receiving the stock may have also received the higher tax burden.   A sale of appreciated stock would result in a tax debt, but gain from the sale of a primary residence will likely be nontaxable if the home appreciated less than $250,000.  The former couple should also consider selling the primary residence if the home has substantially appreciated.  The current exemption for appreciation on a home is $250,000 per spouse.  So, if the home is likely to be sold in the near future and is likely to appreciate to more than $250,000, then the amount may be tax-free if sold sooner rather than later.  If the couple or either spouse has tax liens or debts, then it certainly should be addressed during the property settlement with the help of a tax attorney if your divorce attorney does not have experience in that area.

The couple will have further tax decisions to consider at the time of the divorce.  The parties and their divorce attorneys have some control over the taxability of payments between the parties in the form of alimony and child support.  While child support payment are not deductible by the payor and are not includible as income by the recipient parent, alimony is deductible by the payor and considered income for the recipient.  Therefore, if there is a great disparity in the income tax brackets of the parties, then the parties may wish to consider balancing the payments in consideration.  In addition to structuring the payments between alimony and child support, the parties may determine one will benefit more by being able to deduct the children for income tax purposes.

Additional tax issues can result from the couple’s ownership of a business.  If stock will need to be sold or redeemed as incident to the divorce then the tax consequences should be considered, particularly regarding which party of the divorce will be considered to have sold or redeemed the interests in the business.

Further, if the divorcing couple has retirement benefits under a qualified plan, the parties must consider whether a Qualified Domestic Relations Order, or QDRO, will be needed to transfer the benefits.  The receiving spouse’s benefits, including survivor benefits, will be at risk if this crucial step is skipped, and an improperly drafted QDRO can also have dire tax consequences.  Those thinking a do-it-yourself divorce will suffice will surely wish they sought a good divorce lawyer to represent them.

While a divorce is never a pleasant experience, the pain can be lessened by both parties by properly balancing the tax considerations with their distributions of property, ongoing payments, and other tax attributes.  Seeking advice regarding the tax aspects of your Maryland divorce can leave you in a much better position for starting your new future.

For addition information regarding the tax consequences of your Maryland divorce, please contact Jeff Rogyom at (410) 929-4578.

While most would prefer to obtain an offer in compromise, which reduces the total tax debt, many will not qualify because either their income is too high (by IRS standards) or the taxpayer has too many assets, which includes home equity.  Thus, that taxpayer’s only option may only be to request a payment plan.

To qualify for an installment agreement, the taxpayer will need to be current with their ongoing tax obligations.  In addition, the taxpayer will need to ensure that all required tax returns have been filed.  In many situations the taxpayer may be required to file financial reports showing their income, expenses and available assets.  Depending upon the amount due and time required to pay the amount, the IRS may require documentation of your income and expenses.

If the taxpayer owes a substantial amount to the IRS, then the payment may be in excess of what the taxpayer may be comfortable paying.  Unfortunately, the IRS may require you to make certain lifestyle changes in order to make the payments.  Further, the IRS may require you to include the income of your significant other, even if you are not married, as an available resource.  When IRS required payments are excessive, the taxpayer may be eligible for an offer in compromise or may want to consider filing for bankruptcy to reduce the tax debt.  Further a tax attorney may assist you by appealing unreasonable payment requirements or rejected installment agreements.

A benefit of an installment agreement is that the IRS will no longer be able to pursue most collection actions against the taxpayer, such as a levy against wages or property.  Thus, if you agree to make a $300.00 payment, the IRS will not be able to seize your wages to collect additional amounts.  The IRS payments will be in equal amounts over the designated payment period.  The installment agreement will not stop penalties or interest from accruing in addition to a nominal fee to establish the agreement, so a taxpayer should also consider bank financing in the alternative.

Once the taxpayer has an installment agreement in place, the taxpayer will need to continue making all required current tax payments and file all tax returns.  If the taxpayer becomes further indebted to the IRS, the IRS may cancel the installment agreement for the older debts and resume collection actions.  In addition, the taxpayer’s future tax refunds will be seized and applied toward the debt.  Such additional payments will, however, reduce the installment agreements duration.

A tax professional is often needed to ensure your installment agreement is properly established and to ensure the payments are as reasonable as possible for you and your family.

For further information, please contact Jeff Rogyom at (410)929-4578.

The most common way to minimize your potential liabilities would be to have your properties held by and managed by a separate entity with limited liability.  While you may consider the property to be separate from your personal assets, unless you proactively create that separation, an attorney will pursue your personal assets in addition to the value of the property itself…

To make your LLC effective, it is usually advisable to have the LLC own the property, rather than just manage the property.  If you already own the property, there may be costs associated with transferring the property to the LLC.  Further, your lenders will often need to approve the transfer and will request that you personally guarantee their loans.  Nonetheless, the risk of owning an investment property in your own name often far outweighs the associated costs.

All property owned by an LLC will still be at risk for any liabilities.  Thus, you may consider forming multiple entities if you own several properties, particularly if the properties have significant equity or if one property is very likely to create liabilities.  Further, if you flip properties, then you may wish to create new entities.  Lingering liability from a former property could affect your current holdings.  While allowing the property itself to remain at risk may not sound appealing, the alternative is for all of your personal assets to be subject to claims, including your personal home and your future income.

For tax purposes, the most commonly used entity for real estate investments is the limited liability company, otherwise known as an LLC.  A tax benefit of owning real estate through an LLC is that if the LLC is owned by a single member, then the entity is disregarded for tax purposes.  This means all income and losses from the property would not need to be reported on a separate return, and the amounts can be directly entered on the owner’s personal income tax return.

In addition to transferring your property to the LLC, it will be necessary for all business of the property to be handled exclusively by the LLC.  For instance, tenant leases, the roofer’s contract, and the checkbook should name the LLC as the contracting party, rather than your name.  These formalities will make it less likely that an attorney will be able to pierce the LLC veil of protection that prohibits you from being sued personally.

Often, real estate investors believe their liability insurance will protect them.  Unfortunately, you should not assume a jury will limit its sympathy for an injured tenant to the amount covered by your liability insurance.  Therefore, the only way to truly be certain that liability from an investment property will not lead to you losing your personal assets is to form an LLC.

In conclusion, holding or managing a property in your own name creates many opportunities to be personally sued.  The only way to truly limit your potential personal liability is to form an entity with limited liability protection.

For further information, please contact Jeff Rogyom at (410)929-4578.

Many believe their businesses will receive tax or legal benefits for forming in an alternative state, and legal document mills often perpetuate these beliefs to sell incorporation packages… While some businesses benefit from the differing tax laws of other states, the vast majority of small business realize no benefit and forming in another state only creates financial and administrative burdens. For instance, many sell Nevada as a place to incorporate since there is no corporate income tax, but most businesses will not be able to legally take advantage of that tax difference. In addition, your home state often provides adequate legal attributes and liability protections for your business, despite the often promoted liability protection benefits of having a Delaware entity.

Most major corporations choose to register their companies in a handful of states, and this sometimes creates the perception that companies are doing so solely to limit their tax liabilities. Often these decisions are based upon those states’ corporate governance requirements, meaning certain states do not impose many requirements on how a company must be run or funded. Start-up companies that anticipate selling stock to the public often form in Delaware. Other states provide benefits to companies in certain industries, such as the lax usury laws that may attract banks or credit card companies. This does not necessarily mean, however, that the average small business will receive any benefit by following the lead of these corporations.

For tax purposes, if your company operates in Maryland, then it will be required to file a Maryland income tax return in Maryland. Further, the company’s income that originates in Maryland must be reported on the Maryland tax return as Maryland income. The Maryland tax return must be filed regardless of the state that the company chose for formation or incorporation.  Therefore, unless your company has operations in multiple states, then your company usually has no tax reason to form outside its home state.

A small business registering in another state will run into several problems. First, even if the company is registered in another state, most state’s require the business to also register as a “foreign business” in their state and pay the associated fees. Second, the state may also require the company to obtain an in-state mailing address and hire an in-state person to be the company’s “registered agent”. Unless you have a contact living in the state, then you often will need to pay the local person to perform these duties. Finally, by registering in another state, you may find yourself being sued in that state’s courts. Your registration state’s courts will have jurisdiction to accept a lawsuit filed against your small business and may require you to defend your company in a very inconvenient or unfriendly location.

In conclusion, unless you can identify a specific benefit of being registered in a certain state, then you should generally choose to register in your home state. Few businesses benefit from forming in another state. Further, filing in another state may cause you to incur substantial costs and many administrative and legal burdens.  You should certainly consult your attorney before making a choice that may be very costly to reverse.

For further information, please contact Jeff Rogyom at (410) 929-4578.

Most states, including Maryland, provide you with the following popular state entity choices: the sole proprietorship, the general partnership, the limited liability company, and the corporation. Other entities for more specialized purposes also exist, such as the limited partnership and the professional association (a P.A. or P.C.).

I. Brief summaries of the four most popular entities:

Sole Proprietorship: A sole proprietorship is the default business entity for any business owned by a single person. The sole proprietorship provides no limited liability (discussed in Section III below) protection for its owner. If you have not chosen an entity and have no partners, then this is likely your current entity. It is not recommended that any active business operate in this form given the owner’s exposure to the company’s liabilities and lawsuits. For tax purposes, the IRS requires income from this form of business be reported on your Form 1040′s Schedule C, or, if real estate, Schedule E.

General Partnership: A general partnership is the default business entity for any business owned by multiple owners. Similar to the sole proprietorship, there is no limitation of liability for the business owners, known as its “partners”. The business generally does not need to file with the state to be considered a general partnership. State laws determine if a partnership exists, whether the owners intend to or not. If the state laws determine the group is a “partnership”, then the partners can be liable for acts of the business and their fellow partners. Similarly, IRS tax laws determine whether the group is a partnership for income tax purposes. For income tax purposes, the IRS requires groups it considers partnerships to file a partnership tax return, Form 1065. The partnership issues a K-1 to each partner which informs both the IRS and the partner how much income and expenses the partner should report on their Form 1040.

Limited Liability Company: The Limited Liability Company, or “LLC”, is today’s most popular entity form. It is the most popular because of its flexibility both in its operation and its available tax classifications. To form an LLC, the entity must be registered with the chosen state’s department that registers businesses, such as the Maryland SDAT (State Department of Assessments and Taxation) or the Delaware Secretary of State. The LLC offers limited liability to its owners, known as its “members”. Thus, if the LLC is sued or otherwise becomes in debt, then the members in most situations will not be personally liable to the creditors of the LLC. LLC members can choose how they want the IRS to tax the entity. Without making an IRS election, an LLC generally will be ignored for tax purposes if it has only one member or will be taxed as a partnership if it has multiple members. But, when making IRS elections, an LLC member or members can choose that the LLC to be taxed as a c-corporation or as an s-corporation (discussed in Section II below). A tax attorney would be able to guide you toward the optimal tax classification for your LLC.

Corporation: The corporation, in its modern form, has existed as a business entity for more than a century. Unlike more recently developed entities, such as the LLC, the laws governing corporations are well-developed. Thus, shareholders can be assured there will be few opportunities for a judge to surprise shareholders with their own new laws. The corporation’s business owners, the “shareholders”, have limited liability. This is the entity form best-suited for companies that foresee themselves “going public” in the near future. But the corporation does have its downsides. Corporate laws usually impose administrative burdens, such as annual meetings, that the more flexible LLC laws usually do not. Further, for tax purposes, the corporation must be taxed as a corporation, i.e. unlike the LLC, the corporation cannot choose to operate as a sole-proprietorship or as a partnership, even when the tax filing requirements seem unreasonable. The corporation may; however, elect to either be taxed as a c-corporation or as an s-corporation (discussed in Section II below). To make the corporation more flexible for small businesses, some states have created simplified corporate forms, such as the Maryland close corporation.

II. Tax Issues in Entity Choice:

While states can create new and unique entities, such as Delaware’s “series LLC”, the IRS lumps them together into a limited number of possible tax entities. For instance, there is no IRS tax form for an LLC. Through IRS eyes, a business with multiple members will be either a partnership, a c-corporation, or an s-corporation with few exceptions.

As stated above, while an LLC is normally taxed as a partnership, an LLC may choose to be taxed as an s-corporation or as a c-corporation. If operating as a c-corporation, the corporation pays taxes upon its income, and the shareholders pay taxes when the income is distributed. Thus, a c-corporation’s income is taxed twice. If operating as an s-corporation, the corporation itself generally pays no income tax and the corporate income is taxed only to the shareholder, regardless of whether the income is distributed. Today, most businesses operating as c-corporations are those that have no choice, such as a widely-held or publicly-traded company, and those with out of the ordinary tax situations.

There sometimes are tax benefits to being a c-corporation, and the proponents of c-corporations often proclaim its superiority with a certain level of fanaticism. But, in general, the advantage of an s-corporation’s single-layer of tax far outweighs any benefits offered by a c-corporation. My experience as a tax attorney is that when a small business operates as a c-corporation, there is a temptation to illegally deduct personal expenses through the business in order to avoid the two-layers of tax. An IRS audit of those businesses can be devastating when discovered personal deductions suddenly turn into huge tax bills for both the corporation and the now dividend-receiving shareholder, plus penalties and interest.  Sadly, many such individuals were placed in that position by a tax consultant’s poor advice. Currently, few small companies have a legitimate reason to choose to be taxed as a c-corporation, and the only reasonable decision for most small companies is choosing to be taxed as either a partnership or as an s-corporation.

III. Limited Liability:

Some entities, such as the LLC and the Corporation, offer limited liability to their owners. Limited liability roughly means that the owners are not personally responsible for the company’s debts and that the company’s creditors can only seize the company’s assets, but there are exceptions. If an owner guarantees or “co-signs” for a company debt, then the company’s limited liability will not protect that the person from the co-signed debt. Despite an entity’s limited liability, individuals also can be personally responsible for tax debts created for “trust fund” taxes, such as employment taxes or state sales taxes. Often, by law, certain liabilities cannot be limited by forming an entity, such as civil or criminal penalties or professional liability. Further, if a court determines that an entity’s owners never truly honored the entity’s existence, then courts can sometimes “pierce the corporate veil” to go after the owners. Veil piercing generally occurs when owners fail to properly separate their personal life from that of the entity, such as commingling checking accounts or doing business in the owner’s name. Additionally, courts can pierce the veil when the owners egregiously fail to adhere to corporate formalities, such as never holding required meetings or never seeking corporate approvals when required.

IV. Conclusion:

In conclusion, taking these factors into consideration, a tax attorney should be able to guide you toward the proper entity choice. The excitement of starting your own business should not cause you to rush this very important decision. Seeking proper advice before committing your company to years of high taxes is well worth the investment.

For further information, please contact Jeff Rogyom at (410)929-4578.

Consider what an auditor generally will request from your business for a sales tax audit:

♦ Accounting books, including income statements, depreciation schedules, balance sheets, general ledgers, and federal & state income tax returns.
♦ Supporting documents, such as sales invoices, purchase invoices, sales journals, purchase orders, bank statements, contracts, and leases.
♦ Exempt sales documents, including resale certificates and exemption certificates.
♦ The sales tax returns and supporting workpapers.

It is not uncommon for an auditor to request more information than is needed, and giving the auditor too much or too little information can make the audit an unpleasant experience. Depending upon the nature of the business and the audit method to be used, the needed information can vary. Needless to say, before you start shoveling documents to the auditor, have your tax adviser review the information. Know where problems are before the auditor does.

The auditor will often ask the taxpayer to waive certain rights or to agree to a certain audit methodology. A tax attorney should be contacted before agreeing. For instance, if your company is fully capable of documenting every taxable purchase made during the audit period and the amount is agreeable, why would you agree to an auditor’s suggestion that sampling be used instead? Unfortunately, before making such a decision, most taxpayers do not request a tax adviser review their books and guide them properly.

The auditor will compare the provided information to your sales tax returns and determine whether there were discrepancies. For instance, the auditor can compare your total sales according to your income tax returns to your sales tax returns, or your sales invoices to your sales tax returns. Further, for purposes of the use tax audit, expect the auditor to compare your property tax return and your depreciation schedules to your reported purchases.  But, with that information in hand, an auditor would be presented adequate information to expand the audit from beyond sales taxes and into income, payroll, admissions & amusements, and other tax areas.

The auditor will certainly be searching for underpayments of taxes, but do not assume the auditor will point you toward tax overpayments. You and your tax adviser must be vigilant to spot errors in the auditor’s calculations, sampling methodology, and legal arguments. Further, tax departments often train auditors on the job and your company may be their classroom, so carefully reviewing the auditor’s workpapers and audit reports is a necessity. Experienced auditors expect taxpayers to have a tax adviser review their work, so do not fear offending them by requiring the auditor to justify their adjustments.

While a sales tax audit may not be a pleasant experience, the audit will present opportunities. For instance, if your tax reporting has been flawed in general, it is not uncommon to actually receive a refund. Further, you may be able to take the information obtained from a satisfactory audit and lock-in those results through a managed compliance or effective tax rate agreement whereby your use tax payments can be automated. Such an agreement allows you to aggregate sales and purchases by accounts and pay use taxes by simply applying the account’s agreed upon taxable percentage.

A sales and use tax audit can be a difficult process for a company and its staff. Whether your company is currently under audit or questioning its compliance, proper preparation and guidance will allow the company to minimize its risks and ensure its tax burdens are minimized.

For further information, please contact Jeff Rogyom at (410)929-4578.

A major consideration when purchasing an existing Maryland business should be minimizing the tax burden.  Certain transactions provide tax benefits to either the purchaser or the seller while providing a tax burden to the other.  Therefore, tax consequences should be considered when determining the appropriate purchase price.  The general rule is that the sale of a business is a taxable event; however, the parties may be able to structure the transaction using a tax-free reorganization.  The IRS provides several forms of tax-free reorganizations, but to qualify the parties must meet numerous requirements.  Since the IRS only allows tax-free reorganizations under limited circumstances, I will first discuss taxable transactions.

As a taxable transfer, the buyer and seller have two general options: using stock sale or asset sale tax rules.  Though conceptually similar, I will discuss the tax consequences of a partnership sale in a separate article.  The seller generally favors a stock sale because the seller is taxed upon sold stock using the capital gains rate (15%).  In contrast, an asset sale’s seller may be required to use the higher ordinary income tax rate for certain sold assets.  The buyer generally favors an asset sale, because an asset sale increases the basis of the company’s assets (rather than the basis of the purchased stock).  Therefore, following the purchase of the business, the buyer may sell assets realizing less income tax and may depreciate the acquired assets for tax purposes using the assets’ new, higher basis.

Balancing the buyer and seller’s opposing tax burdens and benefits requires an analysis by a tax expert.  While, as stated above, certain transaction forms are generally better for one party, an analysis of the company and the company’s assets may conclude the tax benefit to one party is minimal compared to the tax burden to the other.  Therefore, well-advised buyers and sellers generally choose transactions favoring the parties in aggregate, rather than favoring the IRS.

To qualify as a tax-free transaction, the transfer must meet IRS requirements.  Generally, it requires the “seller” to remain a partial owner of the resulting company.  There are several forms of tax-free reorganizations appropriate for buying or selling a business.  Each referencing a paragraph of the Internal Revenue Code, the relevant reorganization formats are known as Type A, Type B, and Type C reorganizations.

Each reorganization type requires some compensation be paid to the seller in the form of the purchasing corporation’s stock.  A Type A reorganization requires at least 50% of the compensation value be paid in stock, while a Type B requires at least 80%.  Type A permits compensation using either voting or nonvoting stock, in contrast to Type B which only permits compensation using voting stock.  A Type C reorganization requires the purchaser acquire 80% of the target’s assets and pay the target solely in voting stock.  Regardless of the tax-free reorganization type, amounts paid in something other than stock are immediately taxable.

State and local taxes must also be considered.  In addition to income and corporate taxes, most states will impose a sales tax upon owned or leased tangible personal property transferred during the sale.   This form of sales tax is generally referred to as a “bulk sales tax”.  The Maryland Comptroller’s bulk sales tax imposes a 6% tax on the price of tangible personal property included in the purchase, unless an exemption applies.  The Maryland bulk sales tax does not apply to inventory held for resale, titled vehicles, and certain production equipment.  The Maryland bulk sales and use tax specifically applies to furniture and fixtures, computer software, business records, customer lists, and non-capitalized goods and supplies.

For further information, please contact Jeff Rogyom at (410)929-4578.

Conversations with clients previously cheated by these companies provide me the following tell-tale signs of an unethical tax settlement company:

1) During your initial meeting they do not ask why you owe the tax debt.  A reputable tax attorney first questions whether you truly owe the tax debt and will not consider an offer-in-compromise tax settlement until that issue is resolved.  Unscrupulous tax relief services often push you into an offer-in-compromise based upon your inability to pay, even if they can easily resolve the issue by sending the IRS a couple documents.  Why?  For one, the tax settlement company’s “tax expert” you are speaking to is often trained and compensated only to land offer-in-compromise clients.  Second, the supposed tax expert you are speaking to may not know a single thing about taxes.  Third, the “big money” is not in actually resolving your tax problem, but in getting you convinced the “easier” way is to just do a tax settlement.

2) Unethical companies promise results… great results.  Sure, it’s nice to be confident, but predicting an offer-in-compromise’s amazing success before even meeting a client should be a huge red flag.  Making the IRS accept an offer-in-compromise is no easy task.  Even the most skilled tax attorneys cannot make the IRS accept offers from some taxpayers.

3) They advertise so much you know their name.  One sign a company is not legitimate is if they advertise offer-in-compromise services on television or radio.  Of course, this is not conclusive evidence the company is a scam as I know a reputable Maryland tax attorney who regularly advertises.  But a tax settlement company’s airing of commercials between payday loan and a cash-for-gold commercials should be warning enough.

4) They claim they’ll have your tax problem resolved quickly.  The offer-in-compromise process is slow, sometimes real slow.  An unethical tax settlement company loves to promise how quickly they can resolve your problems.

5) Your company representatives regularly change.  If you have a different representative every other month, you may be dealing with a company that either has serious human resource issues or that doesn’t care that your case is not being properly handled.  By the time a respectable tax attorney completes your offer-in-compromise, the tax attorney should have intimate knowledge of your finances.  This is necessary to adequately represent you before the IRS.  And, needless to say, your contact person should be able to tell you their last name.

6) Your first required deposit strangely reflects how much cash you have.  First, it is regular practice for a good tax attorney to ask that money be deposited before starting a tax settlement case.  Let’s face it, a tax attorney is going to be skeptical about whether someone who has not paid the IRS will readily pay their attorney.  But be wary if the tax relief company asks for a deposit based upon the amount you just told them was in your bank account.  Most real tax attorneys estimate how much your case will initially cost and ask for a deposit based upon that estimate.

7) They use phantom offices.  This is a common practice by offer-in-compromise companies trying to claim to have a local presence.  Google the local address they give you…  better yet, Google every company address in your state, and you’ll likely find their ten Maryland “offices” are actually mailing addresses and conference rooms shared with a dozen other businesses.

8) Unresponsive company representatives… after they have your money.  Of course, after the tax settlement company has your money, it may be too late.  Or maybe not, there’s no reason to throw good money after bad.  Unfortunately, a slow moving representative can cost you a lot of money if your income or status changes during the delay.

9) Just Google them and look for complaints. Now, in defense of anyone practicing in this area, you are never going to satisfy everyone.  Reputable tax attorneys use their best efforts to obtain the best possible results for their clients, and that’s all you can ask of anyone.  But when there are websites dedicated to how bad you are, maybe it’s time to change fields.

10) Go with your gut.  Don’t be afraid to trust your instincts.

If you find you are unable to pay your taxes contact a local tax attorney or accountant.  To see if the tax attorney is actually licensed in your state, your state’s bar association likely provides an online directory similar to Maryland.  If you have already fallen victim to an unethical tax settlement company, you should not be afraid to start over.  There are many reputable tax attorneys who will not take advantage of your situation.  Try to receive a refund and/or contact your state’s Attorney General’s Office to file a complaint if deserved.  The settlement generally requires professional assistance, but I do suggest you familiarize yourself with the process by reviewing the IRS website’s information on an offer-in-compromise.

For further information, please contact Jeff Rogyom at (410)929-4578.